When many people begin investing, they aim to find just the right asset mix to “beat the market.” This means attempting to gain a higher return over time than a commonly accepted index, such as the S&P 500. This inclination is natural but impractical, and research is now showing that it’s nearly impossible over a long period of time.
For this exercise, we’ll look at two kinds of investing – active and passive.
Active vs. Passive Investing
Active investors (i.e. hedge funds, many mutual funds) are those who try to outperform the market. This often involves trading quickly between investments and attempting to predict short and medium-term price trends.
Passive investors own large swathes of the market in small pieces and hold them for a longer period. Their goal is to achieve a return as close to the overall market’s as possible. This is often achieved through indexing, which is like owning stock for every S&P 500 company. Indexing can be done simply by buying a single index-based mutual fund.
There are many approaches among active and passive investors, but these broad classifications are instructive.
Which strategy produces better outcomes in the long run? Let’s imagine we have a hedge fund run by Warren Buffett, who many regard as the greatest investor to ever live. With him on our side, would this hedge fund have a good chance to outperform passive strategies?
It won’t; Warren Buffett himself would tell you that. In fact, in 2008, he famously offered a million dollar wager that after fees and costs, an S&P 500 index fund would outperform any hand-picked portfolio of hedge funds over a ten year period. Protégé Partners LLC accepted the bet, picked the best funds they could, and conceded defeat months before the scheduled end of the contest in December 2017.
How did this happen? Buffet is an active investor himself, yet he knew the index fund would do better. Part of the answer lies in the higher fees charged by hedge funds, which are a boon to the hedge fund managers, not the investor.
The Impact of Fees on Investment Returns
Let’s look at the impact of fees mathematically. Eugene Fama, the 2013 recipient of the Nobel Prize in Economics stated: “Active management is a zero-sum game before cost, and the winners have to win at the expense of the losers.” By definition, the average passive investor (who owns a little bit of the whole market) will see the same return as the market. Since every remaining investor is an active investor, they will on average receive market returns as well, but then must pay the higher fees and commissions needed to execute an active strategy. The average passive investor will therefore always outperform the average active investor. For more insights beyond fees into why active investment strategy performance lags behind passive strategies, see this Economist article.
There will surely be active strategies that outperform passive investing in any given year, but as time horizons get longer, the more surely returns will converge to the mean. But what about an active strategy that is simply better than others? What about a fund manager that is more skilled than their competition? The short answer: To be 95% sure an active strategy wasn’t successful out of pure luck, it takes more years of data than you have left in your life (see this Economist article about this Elm Partners paper).
The Principles of a Sound Investment Strategy
If you can’t rely on finding the smartest fund manager in the business to ensure you meet your financial goals, how should you invest?
While any complete strategy should be made with an individual’s whole financial picture in mind, the following principles should serve as the foundation for your financial plan.
Every investment incurs some risk. For a stock, the ultimate risk is that the company will go bankrupt, while the risk for bonds is that the company or government will default on its debt. Barring these extreme events, risk is measured by how much their prices fluctuate over time.
Investors need to understand that both too much and too little risk can be the enemy of the aspiring retiree. A person would avoid most risks by parking their savings in an insured bank savings account, but inflation would steadily wear down the value of their account. Investing in a single stock invites huge risks, regardless of which stock one chooses. If you had a choice to invest in Kodak or Amazon in 1997, many experts would have advised Kodak. At the time, Kodak was a blue chip stock, but with the advent of the digital camera, today Kodak is almost worthless. Conversely, if you bought stock in Amazon during its initial 1997 offering, today you would have a cumulative return of 49,781%.
Diversification allows a portfolio to live in the ‘Goldilocks zone’ of risk vs. reward. By owning many different stocks and bonds, your portfolio will own successful companies like Amazon to balance against the failures of Kodak. When your savings are more diversified, their value will be less volatile, and you can better plan for the future.
Traditionally, the minimum number of stocks needed to diversify your risk down to the level of the overall market is between 30 and 60, though many experts say that even more are needed. Index and mutual funds help investors diversify by making it easy to invest in a large number of securities with a single purchase.
At TrueNorth Wealth, our portfolios hold thousands of stocks and bonds (and even some real estate) across every type of U.S. company and across a large number of the world’s countries.
2. Low Cost
Nobody invests for free. From trading fees to expense ratios of mutual funds to taxes on your capital gains, your investments experience quite a few drags on their returns. Eliminating those drags can drastically improve the long-term outcomes of your investments.
First, investors need to be conscious of the expense ratios of the funds they invest in. If you invested $100,000 for 30 years and returned 6.9% annually you would end up with $740,169.
However, if your fees had been just .4% higher, you would end up with $78,732 less, a significant difference. This shows how sensitive your investments are to fees. In today’s financial world, a good rule is that any fund with an expense ratio over 1% is quite expensive and one with an expense ratio under .5% is fairly low-cost. You can purchase quite a few Vanguard and Fidelity index funds for less than .1%.
Also, investors should understand that long-term ownership of securities is more efficient. Trading always creates fees. Anytime you sell a stock, you not only pay a fee, but you also incur a taxable event (unless it’s within a tax-free or tax-deferred account). If you’ve held the security less than a year, you pay more tax on it.
Other cost drags on investor returns exist. For example, if your advisor works off commissions (Warning: fee-based advisors still take commissions. Look for fee-only), they take off several percent of your principal as their fee the minute you sign the money over. Advisors also charge fees on the assets they manage, usually as a percentage of assets. Like expense ratios, any fee over 1% should be considered expensive in today’s financial world. Advisors can certainly make up the value of their fee through their expertise, but the higher their fee, the less likely you will come out ahead.
At TrueNorth Wealth, our fees start at well under 1%. We keep our fees low and recommend low-cost funds because we understand how much fees matter to our clients.
3. Tailored for Your Needs
Ultimately, it is vital that both your investment strategy and financial plan are custom-fit for your situation.
To be confident in your plan, you need to be confident in your advisor. At TrueNorth Wealth, we believe it is important to know if your adviser works off commissions or fees.
Commissions are paid when a sale is made and are usually substantial. Mutual and hedge funds can have commissions from 2-3% while other instruments (annuities, life insurance) can have commissions as high as 8-10%. Not only does that hurt your return, but it distorts incentives for your advisor. Without a commission, would they have recommended a different strategy? Is this security simply the one that pays them the highest?
Fees are the solution to the problem of incentives. Fees are charged on assets managed on a yearly basis. When advisors charge through fees, their incentives are simpler and more long-term. When your money grows, their small percentage grows. The happier you are with their service, the longer you will keep your money with them.
At TrueNorth Wealth, we are proud to be low-cost fee-only planners. Our only concern is that your financial needs are met and we aim to provide a long term valuable service to you.
To learn more about our Investment Services, visit our website or call 801-274-1820 for more information.
* Note: Fee-based vs. Fee-only:
- “Fee-Based” firms both charge a fee on assets managed as well as collect commissions on some of the securities they sell.
- “Fee-Only” do not charge commissions
1. Investopedia, September 11, 2017, http://www.investopedia.com/articles/investing/030916/buffetts-bet-hedge-funds-year-eight-brka-brkb.asp
2. InvestmentNews, 10/07/2013
3. “On average, index (passive) investors will always beat active investors. This is (in part) because of fees. Since index funds own the market, they will receive, by definition, market returns. The remainder of the market is owned by active investors, who will see market returns minus the fees they pay active managers to pick securities for them and their trading costs. So the average active investor will always return less than the average passive investor.” - Eugene Fama, Ph.D., Nobel Laureate in Economics, 2013
4. As of Oct 26, 2017, Investopedia